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If you take out a loan to purchase a rental property, you can claim the interest charged on that loan, or a portion of the interest, as a deduction. However, the property must be rented, or available for rental, in the income year for which you claim a deduction.

If you take out a loan to purchase land on which to build a rental property, the interest on the loan will be deductible from the time you took it out. However, if your intention changes and the property is not used to produce rent or other income, you cannot claim the interest after your intention changes.

You may also claim interest charged on loans taken out:

to purchase depreciating assets, or

for renovations, or

for repairs to the property required due to you using it to produce rental income.

Banks and other lending institutions offer a range of financial products which can be used to acquire a rental property. Many of these products permit flexible repayment and redraw facilities. As a consequence, a loan might be obtained to purchase both a rental property and a private car. In cases of this type, the interest on the loan must be divided into deductible and non-deductible parts according to the amounts borrowed for the rental property and for private purposes. A simple example of the necessary calculation is shown in the example Apportionment of interest.

If you have a loan account that has a fluctuating balance due to a variety of deposits and withdrawals and it is used for both private purposes and for rental property purposes, you must keep accurate records to enable you to calculate the interest that applies to the rental property portion of the loan; that is, you must separate the interest that relates to the rental property from any interest that relates to the private use of the funds. An example of this type of arrangement is a line of credit where your salary is paid into the mortgage account.

If you have difficulty calculating your deduction for interest, contact your professional adviser or the ATO.

If you restructure your rental property borrowing arrangements, and you incur a charge for a penalty interest payment-that is, interest that would otherwise have accrued on those borrowings-you may be able to claim a deduction for the amount of the charge. Such a situation could arise where you renegotiate a loan agreement that has a fixed interest rate to provide for a variable interest rate and you are required to pay an amount which represents interest that the lender would have otherwise charged under the terms of the original loan.

If a loan is taken out to purchase a rental property and you start to use the property for private purposes, you cannot claim any interest expenses you incur after that time.

Some rental property owners borrow money to buy a new home and then rent out their previous home. If there is an outstanding loan on the old home and the property is used to produce income, the interest outstanding on the loan, or part of the interest, will be deductible. However, an interest deduction cannot be claimed on the loan used to buy the new home because it is not used to produce income. This is so whether or not the loan for the new home is secured against the former home.

Example

Apportionment of interest

The Hitchmans decide to use their bank's 'Mortgage breaker' account to take out a loan of $209 000 from which $170 000 is to be paid for a rental property and $39 000 is to be used to purchase a private car. The bank officer advises them that they will need to work out each year how much of their interest payments is tax deductible. The officer gives them the following whole year example based on a loan interest rate of 6.75 per cent per annum, and assuming that the property is rented from 1 July.

Interest for year 1 = $209 000 x 6.75% = $14 108

Apportionment of interest payment related to rental property:

Total interest expense

x

rental property loantotal borrowings

=

deductible interest

$14 108

x

$170 000$209 000

=

$11 475

If you prepay interest on money borrowed that covers a period of 12 months or less AND the period ends on or before 30 June 2003, you can claim an immediate deduction. Otherwise, your deduction may have to be spread over 2 or more years under the prepayment rule if the expense is $1000 or more-see Deductions for prepaid expenses.

New rules-known as the thin capitalisation rules-apply in 2001-02. If you are an Australian resident and you (or any associate entities) have certain overseas interests, or you are a foreign resident, these rules may apply if your debt deductions, such as interest (combined with those of your associate entities), for 2001-02 are more than $250 000. If the thin capitalisation rules apply to you, your debt deductions, including interest, may be reduced. Refer to the publication Guide to thin capitalisation (NAT 4461-6.2002) and complete the Thin capitalisation schedule 2002 (NAT 6458-6.2002).

For more information about the deductibility of interest, see the following taxation rulings and determination:

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